Fed to Tighten Regardless of Soft Inflation

July 10, 2017

| Fullerton Markets

Fed to Tighten Regardless of Soft Inflation

Yellen is likely to express her hawkish opinion later this week. Long USD/JPY?

U.S. jobs data in June suggests its economy remains solid after Fed hiked rates for the third time in past seven months

U.S. dollar found some much-needed support from a better-than-expected non-farm payrolls report at the end of last week. It was dominated by Treasuries sell-off again, as the expectation on central bank policy normalisation intensified.

U.S. payroll employment growth rose to 222,000 last month from an upwardly revised 152,000. The jobless rate edged slightly higher to 4.4% from May’s 16-year low of 4.3%, suggesting the economy remains close to full employment. The average work week climbed to 34.5 hours from 34.4, but wage growth remained soft, with average hourly earnings up just 0.2% on the month and 2.5% year-on-year.

Jobs data signalled more cyclical strength behind the US economic expansion but also less structural tightness in labour markets. Allowing the Federal Reserve to proceed gradually on the path to policy normalisation. This could avoid a sharp selling off in U.S. dollar in second half of the year, as euro dollar has a chance to rally in later this year driven by a potential ECB tightening.

Still, traders will focus on U.S. inflation data this week, one of the Fed’s mandates on its monetary policy fixing. After its jobs report said its labour condition remains closed to full employment, U.S. inflation may continue to grow at a slower pace amid continuous soft commodity prices.

Yellen’s testimony to be in the limelight this week

Federal Reserve chair will discuss the outlook for policy and the economy in Congressional testimony on Wednesday and Thursday. Investors will focus on her views regarding interest rate policy and when the central bank plans to start winding back its $4.5tn balance sheet. In its latest meeting minutes released last week, the Fed remained guarded about the timing of reducing reinvestment flows. The minutes noted several Fed officials wanted to announce the start to trimming asset holdings within “a couple of months’’, suggesting September policy meeting may well mark the moment.

Minutes also discussed whether the recent weakness in inflation is transitory. What stood out, were lines from the meeting that rate tightening from the Fed has been accompanied by easier financial conditions, and concern that low volatility could lead to a build-up of risks to financial stability.

Markets may be missing an important message from the Fed as they focus on weakening inflation pressures. Under the cover of high asset prices and a subdued oil price that tempers inflation and financial conditions, it is likely to see further tightening from the Federal Reserve while other central banks discuss nudging policy away from emergency levels of accommodation.

Our Picks

EUR/USD – Slightly bearish. We think this pair may move towards 1.1340 this week.